All kinds of things divide Americans and Europeans -- an ocean, languages, diet, and work habits, to name just a few. You can add another item to the list: The different values they put on stocks, especially technology-related stocks. Despite the recent surge in the euro against the dollar, U.S. tech stocks typically have valuations 20%-25% higher than European peers. That could spell opportunity for investors who take the trouble to look across the Atlantic for technology buys.
The valuation gaps can be striking. For starters, consider Ericsson (NASDAQ:ERICY) and Motorola (NYSE:MOT). The Swedish telecom equipment giant has a price-to-earnings ratio of about 25 times. Last quarter, Ericsson delivered whopping gross profit margins of nearly 45%, and is a leaner, meaner competitor thanks to recent business restructuring. By contrast, Schaumberg, Ill.-based Motorola, with gross margins of 33%, trades on a P/E of 35 times. Sure, Ericsson may not be able to sustain those lofty margins, but even allowing for some shrinkage, its shares are a bargain compared to those of its American peer.
Shares of IT outsourcing specialist, Electronic Data Systems (NYSE:EDS) have taken a beating over the last few months. Even so, EDS trades at a 30% premium to its U.K.-based cousin, LogicaCMG. Both companies provide big, corporate clients with IT outsourcing solutions. But while EDS is beset by finance and contract problems, LogicaCMG -- holding up against fierce competition from the likes of Indian outsourcers Wipro (NYSE:WIT) and Infosys (NASDAQ:INFY) -- is ready for solid growth over the next year.
A glimpse at the semiconductor business shows the same kind of story. German commodity chip producer Infineon Technologies (NYSE:IFX) trades at just 12 times 2005 earnings, compared with 20 times earnings for U.S.-based DRAM chip maker Micron Technology (NYSE:MU), which trades at about 22 times earnings. Besides the earnings valuation, there is little else that sets the two companies apart.
It doesn't end there. Take British Sky Broadcasting (NYSE:BSY), the London-based satellite TV broadcaster compared to EchoStar Communications (NASDAQ:DISH) and DirectTV (NYSE:DTV). BSkyB sports a 2005 P/E of 12 times against its U.S. counterparts at 16 times. If you prefer cash flow comparisons, you'll like BSkyB even more. On an enterprise value-to-free cash flow basis, it trades at just 16 times, compared with EchoStar's multiple of 20 and DirectTV's 27. Over the next five years, BSkyB is expected to generate the equivalent of $4.9 billion before dividends. Controlled by Rupert Murdoch's News Corp. (NYSE:NWS) (owner of Fox Entertainment (NYSE:FOX)), BSkyB owns its programming and has no satellite competitors to speak of in a healthy U.K. pay-TV market.
Mind the gap
So, what explains the gaps? It all boils down to the different ways that European and American investors look at the value of companies.
When it comes to valuing technology-related companies, the basic approach is to build a 10-year forecast, accounting for cash in and cash burn, in what analysts call a discounted cash flow (DCF) analysis. The thing is, forecasting likely revenue in just a couple years time -- never mind 10 years time -- is at best guesswork. Face it, a difference in a license fee of 10%-15% on sales worth $1 billon, or even slight variations on growth and risk assumptions, can translate into a big difference in valuation. As a result, stock prices are driven by investor sentiment and individual views as to the kind of revenues and cash flows the companies will deliver.
U.S. investors, as it turns out, have a bigger appetite for risk. When it comes to valuing a company that has, for instance, made some blunders in the past or, say, carries more debt than might normally be thought advisable, American investors are more willing to forgive and forget than are Europeans. So, their valuations tend to be higher.
You might think that the valuation gap would narrow when you turn from fancy DCF models, to "normal" metrics like P/E and cash flow multiples. Nope. Americans tend to pin higher hopes on the earnings potential of technology companies. The effect is that U.S.-based companies, exposed to more American investors, trade at a premium.
The lesson is pretty clear. If you plan on buying technology stocks, it might just pay to check out Europe. Thanks to Europe's less forgiving and more skeptical investors, stocks there can be much cheaper than those trading stateside.
Caveat emptor
That said, don't get caught in a value trap. Sure, some European stocks look cheap. If it's because the market has yet to spot their true value, great, that probably means the firm represents a buying opportunity. Other times, however, there is nothing to say the valuation gap is wide, because those U.S. stocks are way overvalued.
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Fool contributor Ben McClure hails from the Great White North. Ben owns shares in British Sky Broadcasting, but none of the other companies mentioned here. The Motley Fool is investors writing for investors.
